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Financial Regulation of

Entrance Fee Continuing Care Retirement Communities

Abstract: In the absence of a Statutory Accounting standard regula-

tors rely on GAAP accounting for CCRC oversight. Yet, GAAP account-

ing fails to recognize adequately the nature of Entrance Fee invest-

ments or common refund provisions. This paper makes the case for

Statutory Accounting as a needed standard to strengthen an industry

that has the promise to help resolve America’s looming long term

care funding crisis.

* * * * *

Unlike life and annuity insurance companies, Entrance Fee Continuing Care Re-

tirement Communities (CCRCs) do not now have a Statutory Accounting standard

despite the many similarities between the long term commitments undertaken by

both industries. More particularly there are clear parallels between single premi-

um annuity obligations and Entrance Fee contractual commitments. This paper

advocates the extension of insurance Statutory Accounting to continuing care

contracts since those contracts have many of the same characteristics that have

made Statutory Accounting desirable for life insurance. In the absence of a Statu-

tory standard many regulators have had little choice but to rely on Generally Ac-

cepted Accounting Principles (GAAP), specifically U.S. GAAP, the set of accounting

rules and requirements mandated in the United States. This paper examines the

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effects of this absence of a Statutory standard and how it impacts the public in-

terest in the financial welfare of CCRC residents.

Before we start that examination, though, we should emphasize that the Entrance

Fee model of continuing care is well-suited to the needs of older people facing the

contingencies of age. It allows that segment of the population to apportion their

retirement savings to fund a responsible payment toward the anticipated contin-

gent future cost of their care and sustenance. At its finest it enables people to

provide for their own aging and to avoid dependency on others, either on family

or on state programs for the indigent. By prepaying a large part of that cost of ag-

ing, the elderly are able to maintain their dignity and to look forward to remaining

vital members of society for as long as their health permits. The stewardship of

provider organizations for the consequent Entrance Fees is a high responsibility

involving trust relationships comparable to the long term commitments of life in-

surance.

Kevin McCarty, while President of the National Association of Insurance Commis-

sioners (NAIC), described “the fundamental tenet” of insurance regulation as “to

protect policyholders by ensuring the solvency of the insurer and its ability to pay

insurance claims.”1 The corresponding standard for CCRCs would be to protect

residents by ensuring the solvency of the CCRC and its ability to fulfill its contrac-

tual commitments. In recent years the NAIC has been preoccupied with the im-

plementation of the Patient Protection and Affordable Care Act of 2010 so it’s un-

derstandable that financial and contractual regulation of CCRCs has been neglect-

1 http://financialservices.house.gov/uploadedfiles/hhrg-112-ba15-ba04-wstate-kmccarty-20121129.pdf, p. 2, ac-

cessed August 20, 2013.

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ed. Regulators also have a companion responsibility to foster industry growth.

That requires balanced, principled regulation sufficient to generate public trust

while allowing economic success.

This paper argues that the regulatory standard for CCRCs should be no less than

that for annuities. The clientele at risk in CCRCs is just as vulnerable to a lack of

cogent regulation as are annuity contract holders. Many are more vulnerable.

Moreover, popular concerns with the possibility of financial exploitation through

the Entrance Fee mechanism, which many CCRCs use as a source of free cash,

may be retarding the growth of the CCRC industry. Prospective resident re-

sistance to CCRCs has grown despite the CCRC model’s clear benefits for an aging

population. More effective contract and financial regulation can counter this

concern and may open the benefits of CCRC living to wider popular acceptance.

CCRC regulation in many states is under the jurisdiction of the insurance depart-

ments, so it is appropriate for the NAIC to work on CCRC regulatory issues. In the

hope that the NAIC will eventually turn to CCRC regulation, the National Continu-

ing Care Residents Association (NaCCRA) has developed proposed Statutory

standards most of which are derived from the corresponding NAIC model laws re-

lating to life and annuity insurance.2 Extending the NAIC’s role in Statutory Ac-

counting to the CCRC industry fits within the NAIC’s traditional role.

Why is this necessary? A series of little publicized CCRC bankruptcies have left

residents floundering and have highlighted the low priority given to resident in-

terests by the CCRC industry’s predominant financial structures. Residents, who

2 http://tinyurl.com/ModelLaws accessed February 15, 2014.

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often invest the bulk of their lifetime savings in Entrance Fees, are typically rele-

gated to the category of general creditors in the event of a bankruptcy.

The lack of a Statutory standard has led many regulators to rely on GAAP account-

ing, but as Kevin McCarty noted in his testimony before Congress, just cited, GAAP

“is primarily designed to provide key information to investors of public companies

and looks at ongoing-concerns.” Statutory Accounting Principles are “specifically

designed to assist regulators in monitoring [] solvency […] by using more of a

winding up approach.” In GAAP circles “a winding up approach” is called “liquida-

tion accounting” and it is invoked only when an enterprise is in imminent danger

of liquidation.

For regulators, though, modified liquidation accounting allows the early identifi-

cation of troubled enterprises so that rehabilitative actions can be initiated to

protect the customers, or in the case of a CCRC, the residents. The consequences

for elderly CCRC residents of a financial failure can be dire. GAAP’s focus on cur-

rent, going concern results differs crucially from the alternative Statutory focus on

the avoidance of financial collapse. The difference is such that CCRC residents are

left unnecessarily at risk.

The Actuarial Nature of CCRC Undertakings.

CCRCs, in general, and Entrance Fee CCRCs, in particular, are intrinsically actuarial.

CCRCs involve lifetime commitments; they are structured to serve their residents

continuously from independence through age-related dependence into a dignified

end-of-life experience. Central to the CCRC concept is a commitment to meet the

contingencies of aging when and as they arise. That commitment cannot be met

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unless it is anticipated by the provider, and such anticipation requires actuarial

modeling of the human life contingencies involved.

Logically, one would conclude that the human life contingencies inherent in con-

tinuing care contractual commitments would lead to a conclusion that CCRC fi-

nancial statements require actuarial determinations to achieve matching of reve-

nues with the commitments that the revenues fund and to ensure consistency

with accounting for similar transactions in other contexts. Unfortunately, such

matching and consistency is not required by CCRC GAAP accounting as set forth in

Financial Accounting Standards Board Codification 954-430, which is the rule

which binds American Certified Public Accountants in their practice. Presumably

in the interests of simplification, the accounting rules allow the use of a life expec-

tancy rule.3 This does not achieve the requisite matching since it assigns to the

enterprise all earnings from the investment of Entrance Fees and does not re-

serve an appropriate share to meet the contractual performance obligations in

return for which the Entrance Fees are paid. Moreover, the use of a simple life

expectancy fails to recognize the variations in contractual commitments among

Continuing Care Contracts,4 and those variations are material. Beyond these ac-

3 FASB Codification 954-430-35. Although the codification recognizes the actuarial nature of the requisite deter-

minations to be made, there is no requirement that a qualified actuary be involved. Paragraph 35-2 reads: “With respect to nonrefundable advance fees, if a continuing care retirement community has sufficient historical experi-ence and relevant statistical data about life expectancies, it shall consider that information when determining the remaining life of residents. A continuing care retirement community with insufficient historical experience or relia-ble actuarial data may use relevant data of similar communities within that area, relevant national industry statis-tics, or other appropriate data. Nonrefundable advance fees shall be amortized in the manner discussed in the preceding paragraph.” Judgments about what is sufficient and how best to project the future “performance obli-gations” undertaken is within the particular expertise of qualified actuaries for which they are trained and with which they typically have substantial experience.

4 Contracts vary from full care inclusive contracts to contracts which include no prepaid care and are fully fee for

service with all variations in between. These are material variations affecting future performance obligations and

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counting oversights relating to Entrance Fees, there are also difficulties with the

GAAP accounting for refund obligations which have become increasingly preva-

lent of late in the industry.

From the preceding it may be evident that GAAP CCRC financials, as now consti-

tuted, do not in and of themselves provide a reliable source for Entrance Fee

CCRC residents, or for CCRC industry regulators, but additionally they can also be

materially misleading as a guide for management. Let’s detail why that is so.

Regulatory Significance of CCRCs.

There are some authorities who consider CCRC regulation to be of low im-

portance to insurance regulators. Many states regulate CCRCs outside the juris-

diction of their insurance departments. The NAIC has so far taken little note of

this industry despite the heavy involvement in the regulation of the industry by

member insurance departments in a number of the more advanced states. Still,

any industry that has the potential to help ease America’s looming long term care

challenge ought not to be dismissed as insignificant. This paper takes the position

that continuing care, of which CCRCs are a subset, is of major and growing im-

portance and that it is important that regulators take note of this industry to en-

sure that it can both flourish to meet the need and that it can also operate sound-

ly to protect those who seek the industry’s shelter.

Long term care is a major national challenge. This is particularly so as the demo-

graphic bulge known as the baby boomers moves through old age. The continu-

the expectancy rule makes no attempt to match revenue recognition from Entrance Fees to these deferred obliga-tions.

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ing care industry has the potential to ameliorate this challenge. CCRCs are the

most fully developed manifestation of a financial and contractual undertaking

which allows those approaching advanced age to make provision for their care

contingencies. CCRCs combine continuing care concepts with a coordinated resi-

dential setting. The Life Extension Foundation notes that “All aging humans will

develop some degree of decline in cognitive capacity as time progresses.”5 Mak-

ing advance provision for such exigencies is a responsible act and something to be

encouraged.

Continuing care contracts are contracts of adhesion issued by sophisticated par-

ties, i.e. CCRC providers who are advised by law firms specializing in the industry,

to less sophisticated individuals, who have to accept the contracts unaltered, and

who may do so against the well-considered advice of their personal attorneys and

financial advisors. Those who are enticed to accept such contracts may already

be exhibiting signs of the inevitable cognitive decline cited above though they re-

tain legal competency and can be bound by contracts they are induced to accept.

Thus, both the extent and potential of the continuing care industry and the need

for regulatory protection among those to whom the industry caters indicates a

clear and compelling imperative for regulation. Those regulations should be at

least as extensive and effective as is the regulation to which the life and annuity

insurance industry is subject. Life insurance regulation has developed, been test-

ed, and proven effective over many decades harking back to the mid-19th century.

5 http://www.lef.org/protocols/neurological/age_related_cognitive_decline_01.htm accessed September 14,

2013.

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It can provide valid precedents and insights for conscientious legislators and regu-

lators seeking to ensure a soundly operated continuing care industry.

Desirability of Regulatory Uniformity.

The freedom of American society allows enterprises to operate readily in multiple

states and many CCRC enterprises do. That positive aspect of our culture allows

the rapid upward scaling of businesses that bring positive benefits to the public.

Such constructive growth can be facilitated by uniformity of regulation to avoid

confusion about what is required and to reduce the costs of compliance. Uni-

form regulation could help the continuing care industry to respond to the growing

challenge presented by a rapidly expanding aging population in America. It is a

conclusion of this paper that uniformity can be more wisely achieved at the state

level than by Federal legislation. That conclusion may seem paradoxical so some

elaboration is appropriate.

The Case for State Regulation.

Uniformity can, of course, be achieved by Federal oversight but there are risks

and limitations associated with dependence on Federal legislation. The risk is that

an unintended consequence of a Federal law may drive enterprises out of busi-

ness. That is not an outcome that can be easily reversed, once those businesses

are defunct, if the fallacy in the law is later recognized leading to its repeal. This is

not the case at the state level where an enterprise driven out of one state can

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continue to thrive elsewhere and can simply reenter the inhospitable state later

when the local leaders recognize the adverse consequences of the law.

A second limitation of Federal legislation arises from the doctrine of sovereign

immunity which holds the Federal government to a lower level of accountability

than that which pertains at the state, county or municipal levels of government.

State governments can be subject to Federal oversight so they are not free to op-

erate without accountability. Of course, the officers of the Federal government

are subject to the Constitution and to replacement in periodic elections or, in the

case of the Supreme Court Justices, to the strictures of the Constitution. That

level of accountability, though, does not ensure the same level of oversight as

that which a senior governmental entity can require of one more local, e.g. Fed-

eral over state, state over county, etc. The result is that Federal enactments are

not always uniformly enforced.

These considerations lead to the conclusion that state regulation following the life

and annuity insurance model, with the unifying agency of the NAIC or a similar

entity, is the more desirable approach to effective, uniform continuing care regu-

lation. State initiatives can likewise be a catalyst for addressing the nation’s long

term care challenge in a deliberative and thoughtful way but that is beyond the

scope of this paper though it is a related subject of interest.

For the life and annuity insurance industry, the NAIC has produced a fair degree of

uniformity of regulation among the several states and jurisdictions of the United

States. For the continuing care industry there is no such uniformity in the regula-

tions. One of the more valuable contributions of the NAIC is the opportunity it

provides for states to pool resources, especially concerning technically complex

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matters, so that the quality of regulation is elevated everywhere. This coopera-

tive effort among the states is not now available for continuing care.

To summarize, regulatory uniformity among states can help foster the growth of

continuing care as a publically beneficial industry; can reassure prospective cus-

tomers that promises made will be promises kept; can allow the technical analysis

needed to ensure that inappropriate preconceptions don’t lead to misconceived

requirements; and can fund cooperative efforts to reduce the cost burdens of

regulation for individual states. In addition, people who move to a new state in

retirement are likely to expect the same rigor of regulation in their new state as

that they were familiar with in their home state. With uniform regulation they

will find what they expect.

A Simple Model to Understand Entrance Fee Accounting.

The requirement of Entrance Fees is one of the more distinctive elements of the

CCRC industry. Although there are rental communities, the most common form

of CCRC involves a not-for-profit provider requiring an Entrance Fee. There are

ramifications concerning the details of such Entrance Fees and the nuances of

when an Entrance Fee investment can be recovered, but let’s start simply so that

an understanding of the nature of the transaction can be more readily under-

stood.

The simplest form of Entrance Fee contract is an annuity transaction, so that is a

good place to start. This simple analogy to annuities will show how CCRC GAAP

accounting is inconsistent with the GAAP principles applied to other industries. A

simple life annuity is an agreement in which an advance lump sum investment en-

titles an investor to receive a flat (or uniformly increasing) periodic amount for

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life. For instance, based solely on interest at 3% per year compounded and the

1980-93 California CCRC Mortality study, an investment of $200,000 can fund an

annuity, rounded, of $2,500 per month for the remaining lifetime of an 85 year

old female.

A CCRC, which would otherwise charge a monthly rental, could instead offer an

Entrance Fee contract with an Entrance Fee of $200,000 and a reduction in the

rental otherwise required of $2,500. This is the simplest form of Entrance Fee

agreement. Perhaps a full example can make this clear. Consider a CCRC that of-

fers pure rental contracts, requiring residents to pay a monthly rent for recurring

costs with variable costs, including care expenses, paid on a fee-for-service basis.

The CCRC management might decide to offer an Entrance Fee alternative as a way

to raise cash, say, to invest in the property, or to compete with other Entrance

Fee CCRCs.

Let’s say that the rental CCRC charges $7,000 per month for a particular living unit

with the understanding that the $7,000 rental fee will increase over time as costs

increase. Now the CCRC operator might instead decide to charge an Entrance

Fee, for instance, of $200,000 for a flat, non-inflating reduction of $2,500 in the

monthly rent. Thus, there would an Entrance Fee of $200,000 and an initial

monthly fee of $4,500 with the monthly fee subject to increases as needed. This

conceptualizes how Entrance Fees work. They are an advance payment on future

contractual commitments. The reasonable accounting is to recognize the income

from the Entrance Fees as the deferred commitments are performed.6 With this

6 The mathematics for this simple example (in extended form for a cadre of 300 85 year old women entering a

CCRC and remaining for life with those who die replaced by new 85 year old women) can be examined in an Excel

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simple model, in which the Entrance Fee merely provides a fixed offset to the

rental that would otherwise be needed, it’s clear that the recognition of the En-

trance Fee in income as earned revenue should be level over the duration of the

contract, i.e. over the lifetime of the resident.

Explication of Entrance Fee Mathematics.

The above simple example may seem obvious to many readers but others may

want more elaboration on the underlying mathematics. What seems intuitive to

many may seem unnecessarily complex to others, while still others may dismiss it

as an oversimplification having little to do with the realities of CCRC management.

It’s easy to dismiss as irrelevant what we don’t understand.

At the risk of continuing to focus on simplicity, consider a CCRC that accepts only

85 year old female residents whose health condition at entrance is such that they

will follow the mortality expectations discovered in the 1980-93 California CCRC

Mortality study. We’ll retain our assumption that their Entrance Fees should pro-

vide an investment return toward their deferred benefits at a rate of 3% per year

compounded. We’ll also assume that there are 300 residents; that residents only

leave at death; and that occupancy is always 100%, meaning that residents are

immediately replaced when they die.

Of course, these are unrealistic and impractical assumptions, but they can make

CCRC mathematics clear. While these are gross simplifications, it’s evident that, if

the accounting doesn’t work under these idealized circumstances, it won’t work

spreadsheet which can be downloaded from http://www.naccrau.com/Library/FASB%20Submission%203-1-2012/FASB03012012.html or from http://tinyurl.com/FASBonCCRC.

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under the more complex realities encountered in practice. We can later add in

the complicating factors of early withdrawal; sales lags; vacancy impacts; varying

age, gender, health condition, and marital status; macroeconomic scenarios; etc.

Actuaries are well versed in the accomplishment of these calculations.

Here’s a chart to show how this simplified model would look on a pure mortality

basis before we introduce the complexities of other real world contingencies.

In this idealized model there are new entrants always available to replace those

who die so that occupancy is maintained at the full hypothetical of 300 residents.

Inappropriateness of GAAP for Entrance Fee CCRCs.

GAAP is premised on the concept of an enterprise as a going concern and, only

incidentally, makes provision for the prospect that some enterprises fail financial-

ly. GAAP for CCRCs is defined separately from the principles that determine ac-

counting for other industries. Presumably in a quest for simplification, GAAP

amortizes Entrance Fees into income by a standard somewhat analogous to how a

capital outlay for a building is amortized into expenses arithmetically over an arbi-

300277

253230

206

23

25

25

23

22

24

24

21

23

24

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5

Occ

up

ancy

Pe

rce

nta

ge

CCRC Years of Operation

Succession of Residents (Idealized)

Yr 5 Entrants

Yr 4 Entrants

Yr 3 Entrants

Yr 2 Entrants

First Gen Survivors

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trary period. We refer to this standard as the “expectation approach” since it is

grounded in life expectancy albeit a false understanding of the appropriate use of

such expectancies. The CCRC industry is curiously singled out for special treat-

ment.

That special treatment departs, however, from the principles which govern ac-

counting at its finest. CCRCs serve a vulnerable clientele and so, from a resident

and public interest perspective, the long-term sustainability of the trusted enter-

prise is of greater importance than is the mere period measurement of earnings.

Hence, even if universal accounting principles were applied to CCRC GAAP, Statu-

tory Accounting would still be desirable to give precedence to fulfillment of the

long-term trust relationship involved. But the expectation approach belies CCRC

GAAP even as a valid measure of period earnings. Let’s consider first what those

universal accounting principles are.

The principled GAAP approach consists of the following steps: “(a) identify the

contract(s) with a customer; (b) identify the separate performance obligations in

the contract; (c) determine the transaction price; (d) allocate the transaction price

to the separate performance obligations; and (e) recognize revenue when the en-

tity satisfies each performance obligation.”7 Ironically, or perhaps not, this is the

same methodology that an actuary is trained to provide, even while it is evident

that CCRC GAAP departs from this principled approach, perhaps, in an effort to

minimize the cost associated with the role of actuaries or equivalently qualified

professionals. It should now be clear that many CCRC “performance obligations”

7 http://www.fasri.net/index.php/2011/06/performance-obligations-a-new-era/ accessed April 27, 2013.

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are deferred, and so contingent actuarial mathematics is essential to implementa-

tion of steps (a) through (d) as detailed above. Most accountants do not have the

depth of training in making these evaluations with integrity that well-qualified ac-

tuaries do.

The expectancy approach ignores even the most basic of these steps since it

doesn’t “identify the separate performance obligations in the contract” and, as

noted above, those “performance obligations” vary widely from one continuing

care contract to the next.8 They may even vary over time within the term of a

single contract since the provider typically retains the right to unilaterally modify

the Resident Handbook, which contains many of the “performance obligations” to

be modeled.

Not only does the expectancy approach ignore contract performance particulars

but it also overlooks the time value of money which is an intrinsic part both of an

Entrance Fee contract and of the financing of a continuing care enterprise. The

result is that, in the absence of actuarial reserves, audited CCRC financials are nei-

ther meaningful for regulators nor for management nor for those residents who

seek to know if their Entrance Fee investment is sound.

Consequences of Misleading Accounting.

Not only is CCRC accounting inappropriate in light of the high minded principles

that have historically governed the accounting profession but the discrepancy is

8 Identifying and evaluating such “performance obligations” is of the essence of actuarial modeling. Although the

CCRC industry through its LeadingAge organization has identified a categorization typology for CCRC contracts, demonstrating the wide variability in the performance obligations under such contracts, the expectancy approach pays no heed to those variations and seeks a one size fits all simplified approach to revenue recognition.

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misleading in a particularly odious manner. The expectancy approach overstates

revenue recognition in the early years of a CCRC or in the early years of any indi-

vidual continuing care contract (individual contracts are inherently in their early

years during the early years of a CCRC or major addition to a CCRC). This results in

a new or expanded CCRC appearing to be more profitable initially than it is in real-

ity. This can mislead management into making financial decisions that lead to fi-

nancial challenges later on. The most common result is underpricing which then

leads to deficits as the costs emerge without the anticipated offsetting revenues.

The usual management response, as accounting driven deficits begin to emerge,

is logically enough to drive the monthly fees upward. This creates obvious inequi-

ties between the startup generation of residents and subsequent residents, since

the startup generation not only has the benefit of a newer facility but also bene-

fits from the subsidy provided by misleading GAAP accounting. Later, after the

initial rosy accounting picture, followed by a deficit period, i.e. once the artificial

accounting instigated deficit is made up, the increased fees can prove redundant.

This, in turn, can mislead management into believing its expertise is the cause of

the resulting profits and that the managers and executives deserve bonuses and

other rewards from the emerging margins. These untoward effects are highly

detrimental to the welfare of the CCRC and to the residents whom the CCRC exists

to serve.

An Illustration of the Financial Impacts.

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Following is a comparison of a principled accounting result and the effect of the

FASB rule.9 The principle in play here is that like transactions arising from identi-

cal economic circumstances should result in the same accounting recognition.

Hence, a flat rate annuity that pays a level offset to a contracted rental should be

booked as a level amount. That it is not so booked in the case of a CCRC annuity

undertaking makes manifest the distortion in FASB’s codification for CCRC GAAP.10

For the sake of illustrating the theoretical challenge, the graph above is without

the offsetting above-need fee increases that the ostensible revenue shortfall is

likely to trigger. Some industry experts have dismissed the distortion evident in

9 Projection of a cohort of 300 85 year old female residents with a $2,500 a month flat Entrance Fee annuity.

Deaths are replaced immediately by replacement female residents entering at age 85. Mortality: 1980-93 Califor-nia CCRC, Age Last, Female; interest at 3% per annum compounded.

10 The calculation of the values in the graph can be download in the Excel spreadsheet located at

http://www.naccrau.com/Library/FASB%20Submission%203-1-2012/FASB03012012.html as accessed on May 7, 2013. The explanation for the accounting fallacy, i.e. GAAP’s advancing of revenue recognition to earlier years instead of the evident flat revenue recognition required by matching, lies in the treatment of investment earnings (or debt costs foregone) resulting from the use of the Entrance Fees. CCRC GAAP credits investment earnings to the enterprise as recognized revenue instead of retaining a proportionate share for the benefit of the residents who have prepaid deferred costs. Proper actuarial analysis holds a commensurate share of those investment earn-ings in reserve (and thus out of income) to help meet the cost of the deferred obligations. Today’s GAAP errs in going too far to simplify what is in truth an actuarial calculation comparable to the actuarial reserves that insur-ance companies hold.

$7,800,000

$8,000,000

$8,200,000

$8,400,000

$8,600,000

$8,800,000

$9,000,000

$9,200,000

$9,400,000

$9,600,000

Years of Operation

Rules Based Accounting vs. Matching Principle Based Accounting

Income byMatching Principle

Income by FASBRules

Ten Year Projection

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the graph above as immaterial relative to the overall revenues of an enterprise.

The argument is that the distortion is only 4% to 6% of a truer measure so they

reason that the expectancy simplification of a more complex actuarial calculation

is justified as within the bounds of reasonable materiality. Materiality is an ac-

counting principle. “…the concept of materiality allows you to violate another ac-

counting principle if the amount is so small that the reader of the financial state-

ments will not be misled.”11

Fee increases are of major importance for CCRC managers and residents. In-

creases are adjustments, generally annual, to the recurring and other fees that

residents or participants pay for continuing care benefits. Such increases are in-

tended to offset changes in otherwise unpredictable economic effects that result

in changed performance costs. Increases are typically in the range of 2% to 6%, so

clearly a distortion of 4% to 6% is material for any accounting data which are used

as a guide to management in the determination of needed fee increases.

The Need for Actuarial Recognition of Performance Obligations.

The departure of CCRC GAAP accounting from the matching and consistency prin-

ciples reveals the need for actuarial determinations of all Entrance Fee arrange-

ments regardless of whether contracts are full-care-inclusive, fee-for-service, or

anything in between.12 The life annuity example illustrated here, i.e. an Entrance

Fee that just results in a flat amount deduction from the monthly fee that would

be needed in the absence of an Entrance Fee, is about as simple as an Entrance

11 http://www.accountingcoach.com/blog/what-is-materiality accessed February 15, 2014.

12 There is no standard CCRC contract, only a taxonomy (See http://www.leadingage.org/Article.aspx?id=205 ac-

cessed May 11, 2013).

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Fee concept can be and, yet, even this simple example shows the inherently actu-

arial nature of a lump sum payment in exchange for a contract with lifetime

commitments. The answer is for the CCRC to hold actuarial reserves and to rec-

ognize revenue as the reserves for deferred performance obligations are released

as fulfilled.13

Although the actuarial nature of Entrance Fee contracts is obvious, the actuarial

imperative has not resonated either with the accounting profession or with many

in the industry. The implications go beyond mere financial issues to staffing and

fulfillment questions. Not only do costs escalate with inflation and other forces,

but the probabilities that residents will need assistance services also increase ex-

ponentially with age. Managerial anticipation of these needs calls for actuarial

modeling and evaluation. In such a context the misleading simplicity of the life

expectancy approach is a distraction.

The Challenge of CCRC Refund Accounting.

Although questions related to refund obligations are also inherently actuarial in

nature, and while today’s accounting for such obligations brings into question

common law prohibitions on perpetuities,14 we are not dealing with that in this

paper. Suffice it to say that the recent accounting pronouncements relating to

such refund contracts are particularly disturbing in demonstrating that the Finan-

cial Accounting Standards Board has recognized the difficulty with a partial re-

13 See for instance, United States Government Accountability Office, “Continuing Care Retirement Communities

Can Provide Benefits, but Not Without Some Risk,” June 2010 (http://www.gao.gov/new.items/d10611.pdf ac-cessed February 16, 2014, p. 13.

14 There is a good discussion of perpetuity law in the United States at

http://www.actec.org/public/documents/studies/zaritsky_rap_survey_03_2012.pdf accessed February 16, 2014.

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sponse15 but has not fully addressed it. This partial response may reflect political

considerations more than principle and more than the merits of the matter. Alt-

hough the refund obligations are built into the contracts, the accountants have

adjudged that they are not “performance obligations”, in the sense in which that

term is used in accounting parlance.16

“…instead, the CCRC is effectively facilitating the transfer of cash be-

tween the successor resident and the prior resident. If a restriction

on the amount of the refund is explicitly stated in the contract and it

is the entity's policy or practice to enforce the restriction, … [ac-

counting practices and principles] permit the refundable entrance fee

paid by the unit's initial resident to be deferred and amortized into

income over the life of the facility (reflecting that it is in essence capi-

tal financing).”17

This means that moneys subject to refund may have been amortized into income

and, thus, not available to meet the refund obligation when it comes due (absent

15 http://www.naic.org/documents/committees_e_app_sapwg_2012_fall_nm_agenda.pdf?1 accessed February

16, 2014.

16 The term “performance obligations” is not generally defined though it is widely used in accounting pronounce-

ments (see for instance http://www.fasri.net/index.php/2011/06/performance-obligations-a-new-era/ accessed December 28, 2013) though an article in the Journal of Accountancy includes the following:

“According to the [FASB and the International Accounting Standards Board (IASB) revenue recog-nition] proposal, a performance obligation is a promise in a contract with a customer to transfer a good or service to the customer. The proposal specifies that, if an entity promises to transfer more than one good or service, the entity would account for each promised good or service as a separate performance obligation “only if it is distinct.” Indistinct goods or services could be com-bined with other promised goods or services until the entity identifies a distinct bundle of goods or services, which could result in an entity’s accounting for all the goods or services promised in a contract as a single performance obligation.”

(http://www.journalofaccountancy.com/issues/2012/jan/20114806.htm accessed December 28, 2013).

17 FASB 2011-230, Comment Letter No. 68, p. 5.

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the successor resident constraint), so honoring such an obligation promptly, as a

contracting resident might expect, can place the CCRC under financial strain. This

is a clearly a problem. Life insurance companies are required to pay cash values

promptly after the contract is terminated. Banks are required to honor with-

drawals in a timely manner, often immediately upon demand. But no such re-

quirement is now applied to CCRCs. Life insurance companies and banks are able

to anticipate their liquidity needs and CCRC enterprises can also.

The Insolvency Caper.

Many CCRCs have what CCRC GAAP accounting euphemistically labels as a Nega-

tive Net Asset position.18 Although this means that GAAP liabilities are greater

than GAAP assets, it is not immediately taken as a sign of insolvency. This sug-

gests that the logical conclusions that a user of CCRC GAAP financials might draw

from the document are not meaningful, which calls into question the value of the

GAAP financials as a management or evaluative tool.

As one expert preparer of GAAP audits puts it, “The reader of the financial state-

ments” is encouraged to look optimistically at the possibility that the entity may

have sufficient cash flow to meet its obligations since the test of solvency is “over

the life of the facility.”19 Since the refund obligation is indefinitely deferred due

to the premise of a perpetual organization, we can conclude that CCRC GAAP con-

tends that the facility’s life has no end.

18 See for instance http://www.guidestar.org/FinDocuments/2012/521/281/2012-521281156-08faefe6-9.pdf or

http://www.guidestar.org/FinDocuments/2012/860/335/2012-860335417-099e8eab-9.pdf accessed February 15, 2014.

19 http://info.blumshapiro.com/acton/attachment/2392/f-015d/1/-/-/-/-/file.pdf accessed February 15, 2014.

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Our expert commentator continues to justify this departure from the standard of

integrity that residents might expect to find in the financials since, “this [assets

insufficient to fund liabilities] results when there is a minimal amount of equity

invested in the entity but, instead, the capitalization is ‘financed’ mainly through

either debt or entrance fees received.”20 In other words the management which

exercises the ownership interest has no skin in the game. There is no essential at-

risk equity capital other than the Entrance Fees received. Entrance Fees are often

the primary source of invested equity capital even while the residents are denied

ownership.

Moreover, the residents have but scant standing to petition to put the CCRC into

bankruptcy reorganization. That standing falls to the CCRC managers, or to the

debt holders, and their interests are senior to the residents’ Entrance Fee invest-

ments so they are unlikely to act until the cash to meet the debt obligations dries

up or unless some element of the bond covenants such as vacancy levels is trig-

gered. Consideration of the residents’ interests – funded by the huge cash in-

flows from substantial Entrance Fee requirements – is purely secondary. Primary

are the interests of the debt holders in receiving interest and principal payments

on time and the interests of the executives in remaining in management control

of the organization that employs them. There is a regulatory interest to ensure

that these controlling elements are carefully balanced with the consumer’s rea-

sonable expectation that contractual obligations undertaken will be equitably ful-

filled. As Commissioner Mr. McCarty of Florida noted in his statement cited

above regulators have a primary responsibility to ensure the solvency of a critical,

20 Ibid., p. 4.

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trusted enterprise on which consumers are expected to rely over a long period of

years.21

The History of Today’s CCRC Financial Preconceptions.

At this point the reader may be wondering, how did this flawed and misleading

accounting come to be so widely accepted? The answer is an historical one and it

requires a bit of historical sleuthing. It’s easy to lose sight of how young the CCRC

industry is. Before 1972 the nonprofit senior housing industry was strictly chari-

table with the term "charitable" used in section 501(c)(3) of the Code in its gener-

ally accepted legal sense. “Such term includes the relief of the poor and distressed

or of the underprivileged.”22 Exemption from income tax depended “upon

whether an organization relieves the financial distress of aged persons by provid-

ing care and housing for them on a gratuitous, or below cost, basis.”

In 1972 Revenue Ruling 72-124, cited in the preceding footnote, extended the

meaning of “charitable” with the following major change: “Thus, an organization,

otherwise qualified for charitable status under section 501(c)(3) of the Code,

which devotes its resources to the operation of a home for the aged will qualify

for charitable status for purposes of Federal tax law if it operates in a manner de-

signed to satisfy the three primary needs of aged persons. These are the need for

housing, the need for health care, and the need for financial security.”

This ruling made it possible for an organization to claim tax exempt status if it

provided market based, or even luxury, housing for the elderly with no require-

21 See Page 2 above.

22 http://www.irs.gov/pub/irs-tege/rr72-124.pdf accessed April 21, 2013.

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ment that the enterprise offer “below cost” housing to anyone. Not-for-profit

managers, who had previously been restricted to relieving the housing needs of

indigent elderly people, now had the opportunity to expand their businesses to

offer market priced housing which could support market compensation for execu-

tives and comfortable housing for upper middle class Americans.

Thus it was that “In the very early 1970s, a group of Quakers in the Brandywine

and Delaware Valleys of southeastern Pennsylvania worried about the lack of

good options for living in retirement years.” 23 They then obtained a $300,000

grant from the Philadelphia Yearly Meeting of the Religious Society of Friends to

start what today is known as Kendal Corporation, one of the most reputable CCRC

organizations. They needed financial advice on how to structure the continuing

care contracts financially and for that purpose they turned to David L. Hewitt, a

graduate of Swarthmore College, who served as a pension actuary for Huggins

and Company in Philadelphia.

Mr. Hewitt qualified as an actuary by experience. Based on his work with Kendal

Corporation Mr. Hewitt published a paper in the 1981-82 Proceedings of the Con-

ference of Actuaries in Public Practice, and titled “Actuarial Amortization of Entry

Fees for Life Care Communities.”24 It is that paper which was adopted by Kendal

Corporation initially as the basis for its accounting and that, subsequently, be-

came the basis for what is today the AICPA guidance and the FASB codification.

As an interesting aside Mr. Hewitt lives today in a Kendal community.

23 http://www.kendal.org/documents/KendalAnnualReport2006.pdf accessed April 21, 2013.

24 Paper appeared at pp. 506 to 523 of the cited journal and a copy is available on request from the author.

- 25 -

A reading from the actual process as proposed by Mr. Hewitt in the paper cited

shows a process similar to the simplified methodology that the AICPA adopted, 25

and that FASB has endorsed. The primary difference is that Mr. Hewitt’s method-

ology, in striving for integrity, includes complexities which the accounting stand-

ard eliminated.

Difficulties with this methodology were noted at the time by Alwyn V. Powell, As-

sociate of the Society of Actuaries, and by Conrad Siegel, Fellow of the Society of

Actuaries. Mr. Hewitt acknowledged this input at the time by writing, “A com-

ment sent to me by Alwyn V. Powell says, ‘I would be interested in understanding

how you would modify this approach to accommodate the case in which a com-

munity . . . considers a portion of the entry fee as a prepayment of some future

expenses which would imply increasing earnings per life.’ Also, Conrad M. Siegel

has expressed to me his discomfort that provision for interest credit is omitted

from the amortization procedure discussed in this paper; he questions the argu-

ment at the end of Section IV.”

Mr. Hewitt responded to these comments by considering modifications to his

process. Despite these cautions, as the methodology was adopted by the AICPA

as the accounting standard for CCRCs, the nuances were simplified rather than re-

fined. The accounting process was never brought into line with the requirements

for integrity. The accounting simplification made no allowance for the recognition

of the multiplicity of contractual commitments. In other words, accounting prac-

25 Op. cit., p. 514.

- 26 -

tice has favored simplicity and has ignored or overlooked the unfortunately mis-

leading front ended earnings cited earlier in this paper.

Mr. Hewitt is a mathematician of considerable integrity, and his early involvement

was evidently to try to work within the preconceptions of the accountants, as is

signaled by his use of the word “amortization” in the title of his paper. He was

clearly a leader among actuaries in reaching out to the accounting profession dur-

ing the early years of the evolution of today’s market priced CCRC. Mr. Hewitt’s

growing concern with the resistance of the accountants to actuarial insights is ev-

ident, however, in two successive reports on discussions between the two profes-

sions which he presented first at the International Association of Consulting Actu-

aries 1990 meeting in Auckland, NZ26 and then, two years later at the meeting in

Vancouver, CA.27 In 1990 Mr. Hewitt wrote, “The accountants are attempting to

develop more realistic and informative reporting of CCRC operations. Their princi-

ple setting bodies have recently invited actuarial input to their deliberations, and

we actuaries are gratified at the opportunity for cooperation.”

That hopeful tone had changed by 1992 when Mr. Hewitt titled his report, “Con-

tinuing Care Retirement Communities Encounter Actuarial Progress, but Stiffened

Tensions among Professions.” He then wrote as follows of the sorry state of mu-

tual respect between the actuarial and accounting professions:

26 http://www.actuaries.org/IACA/Colloquia/Auckland/Vol_2/Hewitt.pdf accessed April 22, 2013 (Meeting dates:

February 18 – 23, 1990).

27 http://www.actuaries.org/IACA/Colloquia/Vancouver/Vol_2/Hewitt.pdf accessed April 22, 2013 (Meeting dates:

May 24 – 28, 1992).

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“Accountants frequently accept the findings of other professions in

matters requiring outside expertise. They thus recognize the place of

actuaries in insurance and in retirement plans. But in SOP 90-8 they

prescribe their own answers to problems that remain actuarial. The

accountants still need our help to reach the goal of correct financial

measurement and reporting for CCRCs. We should work together to

solve mutual problems.

“We actuaries have been striving for improved methods of analysis;

the accountants have been engaged in a similar effort, but took for-

mal action before they were ready, affecting most CCRCs. Together,

we need to construct a combined measurement system from which

the two professions can extract harmonious answers.

“Meanwhile, CCRCs needing favorable audit reports, and also desir-

ing to follow actuarial principles, must maintain separate records for

each purpose. This creates confusion for the providers and the pub-

lic.

“The state insurance commissioners who regulate CCRCs are at-

tempting to make use of the advice of actuaries and accountants in

developing their own specifications for financial reporting. They

would like a single, unambiguous, generally accepted formula, to test

the fiscal soundness of a CCRC.”

This sad circumstance of inter-professional dysfunction has persisted till today to

the detriment of CCRC residents, managers, and regulators.

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Review of the Existing Literature.

The adverse effects of this flawed accounting standard are evident in the discus-

sion above. The literature on these matters is scant but it is authoritative. These

misleading effects have been known and well-documented for over thirty years,28

yet they have gone largely unheeded. Most of the existing literature has been

cited in the course of this paper.

The reasons for the lack of judicious financial management, responsive to the evi-

dent issues raised in the literature, may lie in professional preconceptions or sim-

ple hubris. The consequence, though, is that GAAP is not a sufficient standard for

CCRC regulation. There is a need for a Statutory Accounting Standard comparable

to that for life insurance or at least to that required, in a rudimentary form, for

the charitable gift annuities that many CCRC operators market to their residents.

Consequences.

Might a change to a stronger, public-interest regulatory standard for CCRCs result

in a proliferation of identifiable impairments that are now hidden from public

awareness? Perhaps. But, if so, the implicated CCRCs are already insolvent, or

trending in that direction, based on the true underlying economics of the enter-

prises in question. In that case the public needs and deserves a program of reha-

bilitation. It can be done. Denial and concealment are not a valid forms of effec-

tive regulation.

28 Ian A. Morrison, et al., Continuing Care Retirement Communities: Political, Social, and Financial Issues, (New

York, 1986), p. 59 and Howard E. Winklevoss and Alwyn V. Powell, Continuing Care Retirement Communities: An Empirical, Financial, and Legal Analysis, (Homewood, IL, 1984), p. 197 et seq.

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Conclusions.

For regulators and legislators, simply relying on GAAP audited CCRC financials as a

standard for sound CCRC operation is insufficient to protect the public. There is a

need for the NAIC to adapt the Statutory Accounting Standards for insurance to

the analogous operations of CCRCs. An effort to elevate the regulatory standards

for the CCRC industry to the higher level that has governed life and annuity insur-

ers will provide vulnerable seniors with the protection that they need. Only then

will regulators be able to give the public the assurance needed so that prospective

residents can contemplate with confidence an Entrance Fee investment in contin-

uing care.